The next crisis: Fed promised, Fed delivered – James Saft

The next crisis is coming, driven on by Federal Reserve policy which in seeking to keep inflation and employment on target will also breed financial instability.

Don’t take my word for it – this is all straight from Narayana Kocherlakota, President of the Federal Reserve Bank of Minneapolis, who last week laid out his thinking on why low rates will be needed for years to come and what the side-effects will be.

“I’ve suggested that it is likely that, for a number of years to come, the Federal Open Market Committee will only achieve its dual mandate of maximum employment and price stability if it keeps real interest rates unusually low,” Kocherlakota said in a speech in New York.

“I’ve also argued that when real interest rates are low, we are likely to see financial market outcomes that signify instability. It follows that, for a considerable period of time, the FOMC may only be able to achieve its macroeconomic objectives in association with signs of instability in financial markets.”

In Kocherlakota’s view, raising rates would definitely drive both prices and employment further down – and away from the Fed’s mandate. Higher rates would also reduce the risk of a financial crisis, he said, one which could hurt employment and price stability even more. (here)

So, what’s the cost of low rates? Asset prices will be ‘inflated,’ merger activity will rise and those same prices will fluctuate more violently, according to Kocherlakota’s argument. Besides sounding like an investment banker’s drunken dream, this scenario has a rather harrowing familiarity.

Amazingly, Kocherlakota’s remarks came at a conference dedicated to studying the thought of economist Hyman Minsky, who did pioneering work on financial instability and after whom the ‘Minksy moment’ – that point at which the bubble is burst by the weight of its own cynicism – was named.

It would be wrong therefore to call the Fed neurotic. Rather than following the famous definition of neurosis of doing the same thing over and over and expecting different results, the central bank is inflating different bubbles over and over and expecting the same results.

Even more disconcertingly, the only offered salve against the risk of new and damaging financial crises was “supervision and regulation of the financial sector.” Read that last bit as many times as you like, but the words won’t change. The same people who created the mess and missed it last time are going to create another one just like it but this time they’ll, I don’t know, shake their fingers at bankers and the markets in some way which brings order.

OF GLOBAL WARMING AND CENTRAL BANKING

Kocherlakota argued that rather than imposing low real interest rates – meaning rates taking into account inflation – on savers, the Fed was simply reacting to external conditions, in much the same way a sensible Minnesotan would put on a parka when the weather turns icy.

That particular argument is a bit like saying the answer to man-made global warming is for everyone to turn on their air conditioning and open the windows. Sure, it will definitely cool things down a bit, but it shows a lack of understanding about how we got here in the first place.

Fed policy, especially in the years before the great financial crisis, sought to cushion the blow from the dotcom bust through low rates. That worked, up to a point, but it worked by inflating a housing bubble financed by debt.

Low rates contribute to the build-up of debt in the economy, and once that debt has built up, the economy becomes even more dependent on low rates in order to foment borrowing and the activity it drives.

The Fed has very few levers which it can pull to prompt economic activity, but unfortunately the main one, lower rates, seems to work less well and with more risk the greater the level of debt in the economy there is.

As with most useful drugs, there is a law of diminishing returns which applies too to debt and low interest rates.

The truth is that what’s called for is better investment, some of it state-centered like infrastructure, rather than more and worse speculation at lower rates of borrowing.

Now that we are going through another bout of rather weak economic data, it will be interesting to see the way the debate at the Fed evolves. Several members are clearly wary of the impact of extended low rates and asset purchases, and many more would like nothing more than to be able soon to declare victory over the crisis and start to return to normal.

As the evidence mounts that low real rates aren’t having the desired effect but are still distorting markets and making them more dangerous, the Fed may have some difficult decisions to make this summer.

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)